Guide to Startup Equity: Understanding and Evaluating Equity Compensation

Startup equity can be a complex topic to navigate, especially for anyone new to the startup world. Understanding equity in a startup is critical to evaluating an offer to join an early-stage company — and to compare career options. It is important to understand the basics of startup equity, including how it works and how to evaluate it effectively. 

In this guide to startup equity, we’ll cover the basics of startup equity, including how it works and how it is divided among stakeholders. Additionally, we’ll offer insights into how you should think about equity relative to cash compensation.

(We primarily have salespeople in mind, but the principles will apply to any role unless we note otherwise.)

By understanding the ins and outs of startup equity, you can make informed decisions about your future with a company and secure a successful career in the startup world.

Understanding Startup Equity

When joining a startup, one of the most significant benefits can be equity compensation. 

When a startup is formed, it is typically funded by its founders, investors, or a combination of both. Equity is the ownership stake in the company, and it is divided among the stakeholders. As the company grows and becomes more successful, the value of the equity increases.

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Equity can offer a chance to share in the company’s success and earn a potentially substantial payout if the company does well. However, it’s essential to understand the different types of equity compensation and the trade-offs between equity and salary.

Types of Equity Compensation: RSUs vs ISOs

Restricted Stock Units (RSUs) and Incentive Stock Options (ISOs) are two of the most common types of equity compensation. RSUs are a promise to give an employee a certain number of shares of the company’s stock at a future date, while ISOs are the right to buy company stock at a fixed price.

RSUs (Restricted Stock Units) don’t require any upfront investment, and the shares are granted to the employee as they vest. However, they count as income that must be reported for income tax purposes. If the shares are not liquid — which is typically the case for early-stage startups — then the value of the shares is typically set based on the most recent fundraising round. As the name suggests however, illiquid shares can not be easily sold for cash, so there is some inherent risk in using them as compensation.

ISOs (Incentive Stock Options), on the other hand, give the employee the option to purchase the stock at a fixed price in the future. There is no cash value for ISOs that is taxed. Instead, ISO holders simply have the option to purchase the stock at a fixed price in the future. If the stock in fact can be purchased — usually after an exit — then the ISO holder would typically only decide to purchase the stock if its value is greater than the option strike price (which is the predetermined price at which they can purchase the stock) .

Equity vs. Salary Trade-offs

When evaluating equity compensation, it’s essential to consider the trade-offs between equity and cash compensation. Equity compensation can be an excellent way to earn a potentially significant payout if the company does well. However, it’s important to remember that equity is not guaranteed and can be risky.

It is not uncommon that early stage startups — especially those that are short on investment funds — may pay below market rates in cash compensation, but will offer equity packages to help entice talent to join the company.

Typically, employees who join earlier will receive more equity than employees who join later in the same role. Additionally, the strike price for the equity grant will typically increase over time if the company is operating successfully, hitting growth milestones, or raising additional rounds of funding at successively higher valuations.

Cash compensation, whether in the form of base or variable pay (also known as commission), is more straightforward in that you know exactly how much you’ll earn. Base pay is typically fixed, and variable pay is usually calculated based on your performance relative to quota.

Evaluating Equity-based Compensation

In order to evaluate equity-based compensation in a startup, it is important to prepare thoroughly. This involves assessing your own value and researching the company’s potential valuation, stage and equity structure..

Assessing Your Value

Whenever you’re considering a new role, it is necessary to have a clear understanding of your own market value and what you bring to the table. This includes your skills, experience, and expertise, as well as any connections or resources that may be relevant to the startup.

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Another important factor to consider is your level of risk tolerance. Equity in a startup can be a high-risk, high-reward proposition, and it is important to be honest with yourself about your willingness to take on this level of risk.

Researching the Company’s Valuation and Equity Structure

Before joining a startup, it is important to research the company’s equity structure. This includes understanding the current ownership structure, the number of shares outstanding, and any existing agreements or restrictions related to equity.

The best way to get this information is to ask senior executives in the interview process. It may also be helpful to speak with current or former employees, as well as industry experts, to gain a better understanding of the company’s overall financial health and growth prospects. 

In some cases, company leadership will be open in sharing this information. If so, that’s a good sign. It doesn’t guarantee success, but all things being equal, it is more likely that a company that is willing to share these numbers is on a path to success. It also means that the company likely has a culture that values transparency and accountability.

If company executives aren’t willing to share these figures, it doesn’t necessarily mean that you shouldn’t consider working there, but it does raise some red flags. In this case, you should explain why you’re asking. 

This comes down to two factors: 

1. You want to know what % of total shares your shares or options would represent; and
2. You want to understand at what price per share your options would be “in the money” or worth something, should the company achieve an exit via IPO or sale.

You might be surprised to learn that very few prospective employees ask these basic questions about equity. 

Don’t Be Too Confident in the Value of Equity

It’s important to find out as much as you can to support your career decisions. However, you should resist the urge to develop a false degree of confidence in the value of your equity. 

Even if the company offers you perfect transparency into all of these details, it is still impossible to know whether the company will succeed. Some level of risk is always going to be a factor.

By taking the time to assess your own value and research the company’s equity structure, you can evaluate your offer with a clear understanding of your own worth and the potential risks and rewards of equity in the startup. 

Related: What Should You Consider about Being the First Seller at a Startup?

Common Pitfalls to Avoid

Finally, there are a few common pitfalls to watch out for when evaluating your equity package. These include:

• Overvaluing the company or your own contributions
• Focusing too much on equity at the expense of other benefits or compensation
• Failing to do your research and understand the company’s financials and future prospects
• Being too inflexible or unwilling to compromise

By keeping these pitfalls in mind and approaching negotiations strategically, you can increase your chances of making a good decision about your overall compensation package in a startup.

Evaluating the Offer

Once a startup has made an equity offer, it is time to evaluate it. This can be a complex process, but it is important to understand the details before signing on the dotted line.

Understanding Vesting Schedules

One of the most important factors to consider when evaluating an equity offer is the vesting schedule. This refers to the timeline in which the equity will become fully vested or earned. Vesting schedules can vary widely from company to company, but the most common type is a four-year vesting schedule with a one-year cliff.

A one-year cliff means that the first year of equity will not vest until the employee has been with the company for a full year. This means that if you leave – or are let go – prior to one year, you will receive no equity. After that, the equity will vest on a monthly or quarterly basis until it is fully earned after four years. It is important to understand the vesting schedule and how it will impact the value of the equity offer.

Tax Implications of Equity

Another important consideration when evaluating an equity offer is the tax implications. Equity compensation is subject to different tax rules than traditional salary or bonus compensation.

The tax implications will depend on the type of equity compensation being offered, such as stock options or restricted stock units (RSUs), as well as the timing of the equity sale or exercise. It is important to consult with a tax professional to fully understand the tax implications and make informed decisions about the equity offer.

Overall, evaluating an equity offer requires careful consideration of the vesting schedule and tax implications. It is important to understand the details and consult with professionals before making any decisions.

Understanding what your equity is worth

It’s important to understand what your equity is worth before accepting it. There are two important aspects to consider: equity dilution and exit scenarios.

Equity Dilution

Equity dilution happens when the total number of shares in a company increases, which reduces the percentage ownership of each shareholder. This can happen when the company issues new shares to raise capital or when stock options are exercised. As a result, your equity stake in the company may decrease over time.

To understand the impact of equity dilution, it’s important to review the company’s capitalization table (cap table), which outlines the ownership structure of the company. The cap table should include information on the number of shares outstanding, the percentage ownership of each shareholder, and any outstanding stock options or warrants.

Exit Scenarios

Exit scenarios refer to the ways in which you can realize the value of your equity. This can happen through a merger or acquisition, an initial public offering (IPO), or a secondary market sale. It’s important to understand the potential exit scenarios for your company and how they may impact the value of your equity.

For example, if your company is acquired, the value of your equity may be determined by the purchase price and the terms of the acquisition. If your company goes public, the value of your equity may be determined by the market price of the stock.

To better understand the potential exit scenarios for your company, it’s important to review the company’s business plan, financial projections, and any past funding rounds. This can give you a better sense of the company’s growth potential and potential exit opportunities.

Free Equity Calculator Template

Here at RepVue we’ve put together this Equity Calculator that you can use. This model is configured for ISOs, which are the most common form of equity compensation at startups. You’ll be able to adjust the figures to match your specific situation. 

Just going through the process of asking these questions and gathering the answers will put you ahead of most of your peers. In most cases, people don’t know how many shares of their company are outstanding. Without this knowledge, the number of shares that you hold is a meaningless number. It’s meaningful only if you know what percentage of the total outstanding shares your holding represents.

The inputs for the model include:

• Amount raised in the most recent fundraising round
• Post money valuation
• Number of shares outstanding
• Value per share at the time of fundraise
• Number of shares or options that you were granted
• Your “strike price” for your options
• Your company’s ARR (annual recurring revenue)

By inputting these values into the model, you’ll be able to calculate the value of each share (and hence the value of your equity or options), as well as the ARR to value multiple now, compared to the ARR to value multiple at the time of the last fundraise. (Hopefully this number is higher now than it was at the time of the most recent fundraise.)

From all of this information you’ll be able to determine whether the value of each share that you have the option to purchase is greater than the strike price at which you could purchase it. If so, then the total equity value equals that difference, minus the strike price, times your total number of shares.

As a general rule however, we would encourage you to think about equity as potential upside — not as something that you’re counting on. Thinking about your compensation with this mindset is a good way to make sure that you don’t accept a job that won’t pay you what you need to cover your expenses, as well as help protect against living above your means because you are over-valuing the future value of your equity.